Trend Methods
Some technical analysts believe that it is important to identify a
trend that is more likely to persevere over a period of time. In other
words, once a trend has been identified, you should move with it:
In an up market, you should be buying, and in a down
market, you should be selling, until the trend is broken.
Table 11-3
Relative Strength Ratio Between Stock X and Stock Y
Moving Average
The moving average includes the most recent price and eliminates the
earliest price from the figures in the distribution before computing
the average. The moving average is one of the more popular methods
for determining a trend. An average is the sum of a collection of
figures divided by the number of figures used in the numerator; a
moving average is an average over time. Table 11–4 illustrates the
computation of an average for a stock using for a 10-day period.
A10-day moving average adds the stock price for the eleventh
day and drops the stock price for the first day. For instance, if the
closing price on the eleventh day is $18 per share, the new 10-day
moving average will be
10-day moving average = (10-day average + eleventh-day
price – first day’s price)/10
= (165 + 18 –15 3/4)/10 = $16.725
By continuing this method of adding the next day’s price and
dropping the oldest day’s price, the moving average is calculated
over time. You can plot this moving average to show the graphic
trend over time and show how the moving average compares with
daily stock prices. When the moving-average line crosses the line of
actual prices, this indicates a change in trend. The moving-average
line tends to smooth out any volatility in actual daily stock prices.
You can choose any length of time for a moving average: 10, 15,
30, or 200 days, for example. The 200-day moving average is frequently
used, but calculating 200 days of stock prices can be tedious,
particularly if you are interested in a large number of stocks.
Table 11-4 Moving Average
The length of time chosen for the moving average has an
effect on the trend line. Ashorter-duration moving average results in
greater sensitivity to price changes than a longer-duration moving
average. With the former, an investor who religiously follows the
signals given with the frequent crossing of the trend line and the
price line will be encouraged to trade stocks after small changes in
price, as illustrated in Figure 11–9. Technical analysts pay particular
attention to the crossovers of the price line with the moving average,
which indicates a buy or sell signal. The crossing and rising of the
price line above the moving-average line indicates a buy signal. The
opposite situation occurs when the moving average crosses and rises
above the price line, which indicates a sell signal. Ashorter-duration
moving average encourages frequent trading with a volatile stock
price, which results in both greater transaction costs and capital
gains taxes paid, thereby reducing or eliminating any profits. With a
longer moving average, the trend line exhibits a greater lag behind
the actual price line of these stocks. Technicians use the moving
average of the DJIA to determine the trend for the market.
Figure 11-9
Buy and Sell Signals Using a Stock’s Price and Moving Average
A study done by James C. Van Horne and G. G. C. Parker
(1967) suggests that use of the moving average as a tool for buying
and selling stocks does not produce superior results. Another
study done by James (1968, pp. 315–326) indicates that buying and
selling strategies based on moving averages produced lower
returns than a buy and hold strategy.
The fact that investors need to decide on the time period to use
for the moving average and whether they should buy or sell when
the lines cross suggests a somewhat arbitrary and simplistic approach
to the complexities of buying and selling stocks. If a major upward
trend in a stock takes place, an investor profits from it by buying
early. Of course, the opposite is also true. If an investor recognizes a
major downward trend early and sells before the stock decreases in
price, that investor is ahead of the game. However, for stocks that exhibit
volatility, this method may give equivocal signs and encourage
frequent trading, which is costly when transaction costs are involved.
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